A TALE OF TWO HALVES

At the beginning of 2007, investors expected S&P operating earnings to increase approximately 10% for the year after an increase of 15% in 2006.  By the fourth quarter, these profit growth expectations were revised down to 1% growth for the year.   The difficult operating environment for financial and consumer companies accounted for a large portion of the deceleration in S&P profits.  Fortunately, many companies and sectors were unaffected by the credit related problems.  For example, seven of the 10 S&P economic sectors generated impressive double-digit investment gains.  The financial and consumer discretionary sectors were down 19% and 13%, respectively.  It paid to miss these potholes.

The global economy (ex. U.S.) is expected to grow at a 5% rate in 2008 and should support a healthy investment environment.  U.S. growth is slowing to approximately 1.5% and serving as a drag on the global economy, which contrasts with the first part of the decade when our growth sustained the rest of the world.  Many forecasters are anticipating a meaningful slowdown, but there is increasing concern about an economic recession – two consecutive quarterly declines in real GDP.  We expect our slowdown in domestic demand to bottom in 2008, thus setting the stage for a gradual recovery in 2009.  The economy is supported by strength in exports, capital expenditures and government spending, offset by weakness in housing and consumer spending.  Over the last few years, the employment situation has been solid with moderate payroll growth, but there are new signs of weakness that bear watching as employment growth is an important factor for consumer spending.  Throughout most of 2007, consumer spending remained healthy; however, housing weakness, higher energy prices and slumping stocks are moderating consumer spending growth.  This is an important issue because the consumer is the largest component of GDP at 68%.  It would be hard for the economy to avoid recession if consumer spending declines.  As a result of these concerns, the Federal Reserve reduced the federal funds rate by 75 basis points to 3.50% on January 22.  This is the largest one day move in history and highlights the Fed’s concern regarding the weakening of the economic outlook and the increasing downside risks to growth.  In addition, the Administration and Congress are discussing a government stimulus plan of $150 billion in consumer tax rebates and business tax cuts to help moderate our economic slowdown.

The stronger global economy will help the U.S. as we experience a slowdown in domestic demand.  Augmented by a weak dollar, exports are helping to shrink our current account deficit.  For example, the current account deficit as a percentage of GDP is now 5% -- a 30% decline in two years.  Furthermore, the U.S. continues to benefit from foreign capital inflows.  It is important to note that foreigners are increasingly investing in our assets (corporations and real estate) whereas previously our liabilities (bonds and debt) were the preferred target.  The recent list of foreign companies and governments buying U.S. companies is too long to detail in this summary.  The “petro-dollars” from oil producing nations need to be invested and this liquidity potentially provides strong support for our stock and bond markets.  In a related matter, our federal deficit, commonly cited as a “problem”, is well-contained at 1.2% of GDP.

We continue to believe the stock market outlook is favorable, but acknowledge the higher levels of volatility over the last six months indicate increased uncertainty about the market’s fundamentals.  Clearly, the market has been overcome with this theme in early 2008 as we have experienced fear, panic and declining stock prices.  Since October 11, the S&P 500 has declined 24% to the recent January lows.  Stock markets worldwide have also declined sharply in recent days.  These declines are not fully supported by the economic fundamentals and appear overdone.  We expect our stock market to gradually recover in the months ahead.  The near-term GDP outlook may be murky, but the following factors keep us sanguine about stocks: i) monetary policy is increasingly accommodative across major economies ii) Treasury bond yields are less than 3.5% and iii) the stock market is attractively priced at 14x earnings.  These last two points need emphasis as they are key inputs to the “Fed Model”, a credible model relating stock market valuations to long-term interest rates and inflation expectations.  The model currently indicates the stock market is more attractively valued than during most of the last 30 years.